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Defining the Battle Lines: Who Will Be Subject To The Dodd-Frank Act’s Swaps Regulations?

The responses to federal agencies’ attempts to craft rules implementing Title VII of the Dodd-Frank Act’s regulatory requirements for swaps have been diverse, prolific, and at times, prolix. The general media has focused almost exclusively on whether end-users will be subject to margin requirements (the prudential banking regulators say yes, more or less, and the CFTC says no). But less attention has been given to a thornier issue: the extraterritorial effect of the swaps rules.

Photo by Amanda Hatfield. Some rights reserved.

European Banks. The European banks have been particularly attuned to the extraterritoriality issue, both on an entity-level (do they have to register their subsidiaries?), and on a transaction-level (is the trade subject to U.S. law?). Acting individually as well as in groups, the European banks have repeatedly confronted U.S. regulators with questions concerning the Dodd-Frank Act’s application to them. One commenter, albeit an American, noted that the CFTC’s proposed entity swap registration rule considers the use of the U.S. mail (or “instrumentality of interstate commerce”) as a factor in determining whether sufficient U.S. contacts exist to require the application of U.S. law. The European banks further note that they are already subject to their individual country laws and will be subject to European Commission rules. They understandably quake at the prospect of a third set of provisions.

Consolidated Booking Structures. Since most international banks book all their transactions in their home country, regardless of where the transaction is actually executed, their ideal solution to the extraterritorial question is to be exempt — even if a U.S.-based unit executes the transaction for a U.S.-based client in the U.S. They argue that they are already subject to robust and comparable regulation by their home countries, and the U.S. should remember that fact. Being realists, they have also proposed compromises based on how close a transaction’s contacts are to the U.S. With help from Davis Polk & Wardwell, 12 banks from Europe, Asia, and Canada have submitted draft regulations addressing their concerns.

Ironies. Societe Generale noted an irony in the application of U.S. law to international banks. If the U.S. regulators effectively require international banks to create stand-alone units to transact swap transactions with U.S. contacts, those units may actually be more susceptible to losses or financial shocks, since their access to the parent’s capital may be restricted.

U.S. Banks. U.S.-based banks tend to agree with their international counterparts, at least to the extent that the U.S.-based banks have non-U.S. units. They also raise additional questions. For example, how would regulators treat a U.S. unit’s guarantee of a non-U.S. affiliate’s swap transaction with non-U.S. third parties?

Congress Weighs In. On May 17, the New York Congressional delegation added their two cents. Apparently mindful of the inevitable court challenges to the rules, the lawmakers voiced the “Congressional intent” behind the Dodd-Frank Act. They reiterated that the Dodd-Frank Act was meant to apply only to those activities with a “direct and significant connection” to the U.S. They warned against regulatory arbitrage, but at the same time bemoaned the application of proposed margin and capital requirements to the non-U.S. affiliates of U.S. firms.